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Freddie Mac reported net income of $4 billion for the first quarter of 2014, compared to $8.6 billion for the fourth quarter of 2013. The company also reported comprehensive income of $4.5 billion for the first quarter of 2014, compared to $9.8 billion for the fourth quarter of 2013.

Freddie Mac’s net income was $4 billion for the first quarter of 2014, down $4.6 billion from the fourth quarter of 2013.

Freddie says that its previous level of earnings is unsustainable based on a number of evolving factors.

The decrease primarily reflects a shift to derivative losses in the first quarter of 2014 from derivative gains in the fourth quarter of 2013 as long-term interest rates declined.

In addition, the decline in net income was affected by lower legal settlement proceeds and higher income tax expense, partially offset by lower net impairment expense on mortgage-related securities. Absent legal settlements, first quarter 2014 net income would have been significantly lower.

Sustainability

Freddie says that the level of earnings it has experienced in recent periods is not sustainable over the long term. Freddie Mac’s recent financial results, particularly the level of loan loss provisioning, have benefited significantly from strong home price appreciation, which is beginning to moderate.

Freddie Mac’s 2013 financial results also included a significant benefit related to the release of the deferred tax asset valuation allowance. Additionally, the company’s 2013 and 2014 financial results included legal settlements of both PLS litigation and representation and warranty claims. Freddie Mac’s settlements of representation and warranty claims related to pre-conservatorship loan originations are largely complete while PLS litigation is ongoing and additional settlements are expected in the remainder of 2014.

In addition, declines in the size of the company’s mortgage-related investments portfolio, as required by the Federal Housing Finance Agency and the Purchase Agreement with Treasury, will reduce earnings over time. The company’s financial results will also continue to be affected by changes in interest rates, the yield curve, and mortgage spreads, which can cause significant earnings and net worth variability from period to period.

Freddie Mac’s earnings may be volatile due to changes in the fair value of the company’s derivative portfolio, which is used to reduce Freddie Mac’s exposure to interest-rate risk.

Fair value changes on derivatives are included in earnings, while fair value changes associated with several of the types of assets and liabilities being hedged are not. Therefore, there can be timing mismatches affecting current period earnings, which may not be reflective of the economics of the company’s business.

Freddie Mac’s comprehensive income was $4.5 billion for the first quarter of 2014, down $5.3 billion from the fourth quarter of 2013. The decrease was primarily driven by lower quarterly net income.

Freddie Mac and the FHFA continued to reach agreements with a number of institutions to settle litigation related to Freddie Mac’s investment in certain private-label securities. These settlements contributed $4.5 billion to Freddie Mac’s pre-tax income in the first quarter of 2014, compared to $4.8 billion in the fourth quarter of 2013.

Additionally, Freddie Mac entered into agreements with a number of its sellers to resolve certain representation and warranty claims which related to pre-conservatorship loan origination activity, in exchange for one-time cash payments. These payments contributed $0.3 billion to the company’s pre-tax income in the first quarter of 2014, compared to $0.8 billion in the fourth quarter of 2013.

Conservatorship

Freddie Mac has been operating under conservatorship, with FHFA as conservator, since September 6, 2008. The support provided by Treasury pursuant to the Purchase Agreement enables the company to maintain access to the debt markets and have adequate liquidity to conduct its normal business operations. Based on Freddie Mac’s net worth of $6.9 billion at March 31, 2014, less the 2014 capital reserve amount of $2.4 billion, the company’s dividend obligation to Treasury in June 2014 will be $4.5 billion.

Including the June 2014 dividend obligation, Freddie Mac’s aggregate cash dividends paid to Treasury will total $86.3 billion, $14.9 billion more than cumulative cash draws of $71.3 billion received from Treasury through March 31, 2014. Under the Purchase Agreement, the payment of dividends does not reduce the outstanding liquidation preference. Accordingly, Treasury still maintains a liquidation preference of $72.3 billion on the company’s senior preferred stock as of March 31, 2014.

In August 2012, the terms governing the company’s dividend obligations on the senior preferred stock were amended. The amended Purchase Agreement does not allow the company to build capital over the long term. Beginning in 2013, the required senior preferred stock dividends each quarter equal the amount, if any, by which the company’s net worth as of the end of the preceding quarter exceeds an applicable capital amount. The applicable capital amount is $2.4 billion for 2014, and will be reduced by $600 million each year thereafter until it reaches zero on January 1, 2018.

The amount of remaining funding available to Freddie Mac under the Purchase Agreement with Treasury is currently $140.5 billion, and will be reduced by any future draws.

Modifications, HARP, Legacy Portfolio, Delinquencies

Freddie Mac helps struggling borrowers retain their homes or otherwise avoid foreclosure. During the first quarter of 2014, the company completed over 34,000 single-family loan workouts, including nearly 19,000 loan modifications. This brings the total number of homeowners the company has helped to avoid foreclosure to over 987,000 since the beginning of 2009.

HARP and other relief refinance loans represented 21% of the UPB of Freddie Mac’s single-family credit guarantee portfolio at March 31, 2014. HARP loans generally reflect many of the credit risk attributes of the original loans, particularly LTV ratios, and thus generally present higher risk to the company than other refinance loans the company has purchased since 2009. However, in many cases, the borrowers’ payments are reduced through HARP refinancing, thereby strengthening the borrowers’ potential to make their mortgage payments.

Freddie Mac’s 2005-2008 legacy single-family book continues to represent a declining portion of the company’s single-family credit guarantee portfolio. At March 31, 2014, the 2005-2008 legacy single-family book represented 15% of the UPB of the company’s single-family credit guarantee portfolio, but accounted for 77% of the company’s single-family credit losses during the first quarter of 2014. The gradual reduction of Freddie Mac’s 2005-2008 legacy single-family book has positively impacted the payment performance of its overall single-family credit guarantee portfolio.

Total single-family loans (including relief refinance loans) purchased by Freddie Mac in the first quarter of 2014 had a weighted average original LTV ratio of 77% and a weighted average FICO score of 740. Recent trends in LTV ratios and credit scores reflect, in part, a higher proportion of home purchase loans in the company’s loan acquisition volume and continued purchases of HARP loans.

Single-family serious delinquency rate was 2.20% at March 31, 2014, compared to 2.39% at December 31, 2013. The company’s single-family serious delinquency rate is substantially below the rate for the entire U.S. mortgage market. According to the Mortgage Bankers Association’s National Delinquency Survey, the serious delinquency rate on first-lien single-family loans in the U.S. mortgage market was 5.41% at December 31, 2013, which is the most recent date for which data is available. Freddie Mac’s delinquency rates continue to be affected by delays, including those due to increases in foreclosure process timeframes, general constraints on servicer capacity and court backlogs (in states that require judicial foreclosure process).

Multifamily delinquency rate (based on loans 60 days or more past due or in the process of foreclosure) was 0.04% at March 31, 2014, compared to 0.09% at December 31, 2013, reflecting continued strong multifamily portfolio performance.

Trey Garrison is the Senior Financial Reporter for HousingWire.com. Trey has served as real estate editor for the Dallas Business Journal, and was one of the founding editors of D CEO Magazine. He has been an editor for D Magazine — considered among the best city magazines in the United States — and a contributor for Reason magazine.

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